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Lessons From The GFC – Beware The Next ‘Soft Landing’ Calls

Courtesy of ZeroHedge. View original post here.

Authored by Constantin Gurdgiev via Manning Financial,

Recent months have seen a steady and growing flow of institutional investors', and market analysts', and researchers' warnings about the medium-term sustainability of the financial assets prices. Both, the IMF and the Bank for International Settlements (BIS) have documented evidence on the buildup of systemic imbalances across the financial markets, from bonds to stocks to structured financial instruments. And the Claudio Borio-led research team at the BIS have shown time and again that systemic financial crises are increasing both in frequency and severity.

By all measures, the financial markets are over-pricing forward expectations and underpricing risk. Various estimates suggest that globally some $20 trillion worth of government and private debt traded in the markets is currently priced at a gross underestimate of risks implied by the path of the monetary policies and borrowers' debt carry capacity. The stock markets are showing signs of excessive concentration and share prices are on fire: even as past buybacks and current accounting standards continue to inflate earnings, S&P 500 median price­to-revenue ratio is hitting all time highs of c. 250 percent, compared to the bubble peak of 170 percent and pre-GFC bubble high of 180 percent. U.S. stock market valuation is currently running at just over 135 percent of GDP — the second highest reading in history after 152 percent mark hit at the peak of bubble and well above 110 percent peak before the GFC collapse.

All signs to-date are that the longer the bull market continues to run, the sharper the upcoming crisis will be. Which brings us to the point of what lessons from the last decade of crises, crashes and recovery should the investors rely upon in preparing for the next crisis.


The first lesson is about the difference between normal risk and the VUCA (volatile, uncertain, complex and ambiguous) environment.

While investment is a risky business on a good day, in crises, traditional risks are amplified by rapidly evolving price and trading cost volatility, broad markets uncertainty, systems and networks complexity, and loss ambiguity. Behaviourally, this means that investors' reaction to crashes and longer term crises is unpredictable and investment portfolios values during these periods cannot be assessed with any degree of accuracy. Events that no one could predict in advance, such as large scale sell-offs, massive widening in bid-ask spreads (cost of trading), reversals of historically reliable correlations between asset classes, and failures of traditional hedging and safe haven assets to absorb risks can become the order of the days, weeks, months, even years. In other words, markets crises cannot be weathered without a prior preparation and constant vigilance.

Passive investment is not an option, and active management comes at a ballooning cost.

One important corollary of this is that during markets crashes, quality of professional advice available to the investors often deteriorates. Recent academic studies have shown that during the Global Financial Crisis (GFC) and the Great Recession, analysts' forecasts had extremely low predictive power, leaving retail investors with advice that was poorer in quality and leading to costlier trading and investment mistakes. Ratings agencies and banks are virtually useless and highly conflicted when it comes to predicting the crises and supporting investors during the systemic markets corrections.

Investor response to this reality should involve doing your homework early, in advance of the crash, and securing a good trusted adviser that you work with in normal times as a sounding board for your trading and investment ideas during the crisis.


Financial risk is a function of three things: the price at which you enter the investment, the timing of exiting the allocation and the round-trip cost of trading. This means that for those with staying power (unlevered and longer-term investors), crises are the time when asset prices undershoot their fundamental values, effectively de-risking asset returns. In other words, crises are the time to buy. Counter-intuitively, the time when market-measured risks are at their highest is the time when investment risk is at its lowest.

However, the uncertainty factor— covering the future direction of the markets post-crisis — increases the risk of entry and exits (cost of trading) and the risk of short-term negative returns. An investor buying into a falling market simply does not know how long and how far the market can fall from the point of their purchase. Which means that to benefit from the sharp market corrections, investors should rely on cash when buying at the market lows. This, in turn, means that investors should consider booking profits before the crisis, when liquidity is still available and the trading costs are lower.

The problem is that, as the GFC has taught us well, traditional financial markets risk models are utterly useless in predicting major market crises timing, duration and depth. Sensing build ups of financial imbalances, understanding inherent risks in assets that are being bid up in the run up to the crisis, and tracking the herds of investors sloshing liquidity from one fad to the next requires subjective, human analysis based on data. So timing crises is more in the domain of arts and less in the domain of hard mathematics.

Having cash in hand when the crisis hits is also about fighting personal greed. Too often, as was the case with many investors pre-2008, a run up to the bear markets involves mis-allocation of cash to higher yield instruments. Much of cash management involves chasing higher returns by trading liquidity for marginal returns (few basis points paid out by the banks on termed deposits). Greed, as a motivator for action, looms larger when market valuations are at their highest. However, to have ready funds to invest in distressed assets requires holding assets that are not subject to liquidity squeezes and do not lose value when markets tank. Which means you have to fight your own behavioural biases and stay away from chasing small gains in the money markets in order to have cash in hand.


Investors tend to see the latest traded price of a security as its market value. This is false for a number of reasons.

One is the low transparency of today's market prices: with over-proliferation of over-the-counter venues for trading in financial instruments, quoted market price is just one signal of value.

Another is the decreasing informational content of executed trades during sharp market downshifts, when unquoted liquidity risk matters more than quoted prices.

The third is the dynamics of prices going into the market peak period, when investors' exuberance pushes prices away from  fundamentals-justified values. Last, but not least, quoted prices ignore trading costs that tend to blow up at the time of markets corrections on the sell side of transactions and at the times of markets inflation on the buy side.

Skepticism about informational signals contained in ticker prices is warranted at the times of markets exuberance. Contrarian view is in order when markets hit the breaks.


Investment allocation is one half of the portfolio management exercise. Risk mitigation is the other.

The first principle of risk management is the stop-loss rule. Behavioural psychology generates biases that skew our decision-making toward erroneous choices, and overcoming these requires serious effort on behalf of an investor. One key set of biases involves the endowment effect and the status quo bias. Jointly, these imply that faced with rapidly escalating VUCA environment, investors prefer staying the previous course to a course of quickly realising early losses. The greater the losses sustained in the downward market to-date, the stronger is the propensity to do nothing. In the end, investors over-hold their long positions and end up magnifying market-induced losses. Thus, the conservative view of one's portfolio is the best position for entering a financial crisis: when you feel that the markets have turned or are about to turn for a sustained downward correction, sell to book either profits or to minimise losses. Being conservative and risk-conscious helps to maintain a longer-term focus on your investment objectives.

The second principle applies to the times of market panics. In terms of hedging, keep in mind that risk hedges and safe havens are only good when entered prior to the crisis onset. Once the crisis is in full swing, you will not be able to either roll over or increase your hedges.

The third principle that should not be overlooked is that only commitment to a flexible, measured and diversification-focused investment approach can provide a long-term offset to the deeper uncertainty that sweeps the markets at the times of panic selling. Portfolio rebuilding opportunities presented by sell-offs are generally dispersed across a range of sectors and instruments, asset classes and geographies. Staying with pre-crisis allocation strategies can be a costly proposition, subject to severe familiarity bias and base rate neglect errors. The former refers to the fact that investors miss new opportunities because we fool ourselves into believing that we 'know well' specific sectors or assets, irrespective of the underlying realities of the market. The latter means that we often assign pre-crisis probabilities of success to assets we are familiar with, irrespective of the changes that the crisis might bring around.

The same applies to managing cost of rebuilding your portfolio during the crisis. Volumes of evidence show that in all markets, when prices fall, volumes of assets available for sale rise, and numbers of buyers shrink. This results in lower cost of trades for the buyers. The converse happens when markets turn to the upside, when cost of buying rises relative to selling. Hence, buying into the falling market can be more advantageous than waiting for the market to bottom out. Of course, this also means that having bought into the falling market you will need to be ready to endure a period during which your portfolio value will continue to decline alongside the market. The key to surviving through this is: avoid leverage and do not gamble away that cash which may be needed to cover your normal expenses and legal liabilities.


Which brings us to another lesson that must be learned from the last decade: stay away from leverage and beware of all hidden forms leverage can take. For institutional investors, this means closely matching duration of their portfolio assets to maturity profile of their borrowings. And this holds for normal times. In markets nearing correction, duration of portfolio holdings can be a tricky matter. This means that institutional investors should constantly monitor their debt exposures and stress test their assets against both liquidity risks and potential liabilities-related risks. For retail investors, the rule is avoid leverage at all costs. When a broker or a banker comes knocking with offers of margin accounts and loans for investment purposes — do not open the door.

Beyond direct debt, you should pay attention to assets you're invested in. Many instruments sold today to a range of clients are built on leverage. While purchasing these does not expose you to direct debt, your returns are still subject to leverage risk held by the fund you are buying into. At times of extreme markets uncertainty, leveraged assets lose their liquidity and their value collapses much faster than for their unlevered counterparts.

Leverage is both, the fuel of the crisis and often the cause of it. Excessively lax lending standards create vulnerabilities in the financial system by raising debt loads across the economy and by lending to customers without any resilience to even minor risks. This holds for corporates and households alike. But the same lax standards also push asset valuations beyond their fundamentally-justified values, creating asset price bubbles.

The faster the lending bubble inflates and the longer this inflation continues, the greater will be the eventual collapse. Leverage risk excesses, in this case, will invariably result in the breakdown in historically-established correlations between assets returns, as witnessed in 2008-2009.

Final point worth stressing when it comes to leverage risk is that investor-own degree of leverage is, in part, a function of their disposable income and their non-investment liabilities. In this context, a smart investor will never face a market crisis with significant exposures to future expected tax liabilities. Getting your house in order before the crisis, and being prepared to cover these liabilities without the need to rely on selling assets into a falling market (incurring losses and higher costs of such trading) can be extremely important.


As a fintech investor and adviser, I enjoy the excitement of working with innovative companies. As an investment markets analyst and researcher, I see financial innovation as a major risk.

The GFC, and indeed the entire history of crises before then, taught us that financial innovation can be extremely dangerous for the investors. New technologies and products in finance are the unknown unknowns when it comes to their performance in the downturns. They also submit to no established or testable hedging. Being long innovative products and technologies means you can neither control their downsides, nor can you account for their impact on your portfolio.

Beyond this, many innovative products are focused primarily on securing higher leverage, hidden behind fancy labels and structuring formulas. Mortgages Backed Securities and other ABS Products c. 2007-2008 are the case in point. So going into a crisis, investors should not hold any serious exposure to the financial innovation or financial services sector more broadly, with exception, perhaps of financial utilities: insurance companies with established, non-financial lines of business.


The above points bring us to the financial markets regulators' and Government's role in the crises. While all of these entities claim to hold investor interests at heart, none of their claims are worth a single penny when it comes to the financial crises. The Italian banks rescue this year shows that all the new resolution mechanisms designed to deal with the future banking crises are nothing more than paper tigers.

The governments will respond to the next crisis in exactly the same way they responded to the previous one: pumping more cash into the markets and re-inflating debt assets first, followed by equities. This means that timing-wise, public assets are more likely to show earlier recovery than private assets.

An investor can and should be ready to capture this upside, even though the uncertainty about the extent and timing of supports is now higher due to a long period of aggressive monetary expansion that we are still going through.

In the meantime, neither the regulators, nor the governments will be of any use in helping investors avoid the upcoming GFC 2.0. With them, rating agencies, and a host of industry lobbying and advisory bodies will also stay silent on the building risks threatening the system. So when regulators and governments start talking about the next 'soft landing' — run for the hills, go to cash, and sit back for the next opportunity to buy into the falling prices.

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